Lesson 3.1 Flashcards
managers face decisions characterized by 2 conditions:
1) strategic nature
2) incomplete info
define risk
hazard or chance of loss
define probability
the likelihood or chance that something will happen
what is P(outcome A) with frequency definition of probability
r / R where R is number of times situation is repeated and if outcome A occurs r times
define frequency definition of probability
an event’s limit of frequency in a large number of trials
define subjective definition of probability
the degree of a manager’s confidence or belief that the event will occur
define probability distribution
a table that lists all possible outcomes and assigns the probability of occurrence to each outcome
2 rules in probability distribution
1) probabilities must sum to 1 if outcomes are mutually exclusive
2) probabilities cannot be less than 0 or greater than 1
formula for expected value of profit
sum of profit * probability for each outcome
define decision tree
a diagram that helps managers visualize their strategic future
what does decision tree represent?
represented situation as series of choices, each of which is depicted by a fork
explain decision fork
represents choice by which managers must commit to a strategy; represented by squares
explain chance fork
represents point at which chance influences the outcome
what do we do when a branch is nonoptimal?
we place 2 vertical lines through it
value of perfect info
the increase in expected profit if manager can obtain completely accurate info concerning future outcomes
why do managers purchase info?
to reduce uncertainty from imperfect or incomplete info
what is expected value of perfect info also?
reservation price for obtaining info (expected profit with perfect info - expected profit without perfect info)
define utility function
function used to identify the optimal strategy for managers conditional on their attitude toward risk / level of satisfaction attached to each possible outcome
what is the rational manager?
one who maximizes expected utility
what is utility?
value that is attached to all possible outcomes of the decision by manager
relationship between utility and monetary gain
Utility generally increases with monetary gain
x axis and y axis of utility function
profit/wealth on x axis and utility on y axis
define risk averters
when managers prefer a choice with a more certain outcome to one with a less certain outcome, when confronted with gambles offering equal expected wealth
graph of utility function of risk averters
Graph increases with decreasing slope; diminishing marginal utility
relationship between utility and monetary gain for risk averters
Increase in monetary gain of $1 is associated with smaller and smaller increases in utility as wealth/profit grows
define risk lovers
when managers prefer a gamble with less certain outcome to one with a more certain outcome when confronted with gamblers offering equal expected wealth
relationship between utility and monetary gain for risk lovers
Increase in monetary gain of $1 is associated with larger and larger increases in utility as wealth/profit grows
graph of utility function of risk lovers
Graph increases with increasing slope; increasing marginal utility
define risk neutral
when a manager maximizes wealth, regardless of risk
relationship between utility and monetary gain for risk neutral
Increase of $1 in monetary gain is associated with constant increase in utility as wealth/profit grows
graph of utility function of risk neutral
Increasing graph with constant slope; constant marginal utility
utility function for risk neutral
utility is linear function of profit/wealth (U = a + b(profit)) where b is positive
expected utility for risk neutral
E(U) = a + bE(profit)
when is expected utility maximized for risk neutral
Expected utility can only be maximum when expected profit/wealth is maximum
define standard deviation
a measure of variation or dispersion of a payoff about its expected value
formula for SD
(sum of probability of occurrence * (profit - expected profit)^2)^0.5
what does larger SD imply and why
Larger standard deviation implies greater risk; there is a greater likelihood probability would depart greatly from expected value
what do managers assume when using SD as measure of risk
When using standard deviation as measure of risk, managers assume scale of project is held constant
do larger investments have larger standard profit deviations?
yes
how do we take into account scale of project when measuring risk?
To take into account of scale of project, measure of relative risk is required, this is the coefficient of variation
formula for coefficient of variation
V = standard deviation / E(profit)
define certainty equivalent approach
when a manager is indifferent about certainty and a gamble, the certainty equivalent (Rather than expected profit) can identify if the manager is a risk averter, risk lover, or risk neutral
if certainty equivalent < expected net worth
risk averter
if certainty equivalent > expected net worth
risk lover
if certainty equivalent = expected net worth
risk neutral
how can we estimate certainty equivalent?
indifference curves
why do indifference curves for certainty equivalents slope upwards to the right as opposed to the ones in chp 3?
because the manager prefers less risk to more risk
graph of indifference curves for certainty equivalent axes
Indifference curve graph has x-axis expected net worth and y-axis is risk (coefficient of variation), x axis where y = 0 is certainty equivalent
what will indifference curve be if risk neutral?
horizontal
what do indifference curves show?
certainty equivalent corresponding to various uncertain outcomes
how to find risk premium from indifference curves?
from riskiness of investment, do ERR at riskiness - ERR at y intercept
range of values SD can take
0
